China is less likely to regulate the variable interest entity (VIE) structures of internet companies – a relief for those that list overseas.
S&P Global Ratings revisited the VIE risk of Chinese companies last week, saying that the likelihood of regulatory action against VIE structures had diminished. Thanks to the foreign investment law that China intends to implement at the beginning of next year, companies that want to list abroad will have fewer concerns when forming a VIE structure about accepting foreign investors.
The VIE structure was developed by Chinese lawyers about 20 years ago. With the Chinese government still cautious about foreign investment in internet and other sensitive businesses, companies that wanted to list overseas had to form a foreign-owned enterprise in China to enjoy the profits of the Chinese subsidiary, while also separating the licensing and intellectual property to the Chinese entity.
For years, the VIE structure was viewed as a high regulatory risk because the Chinese government never approved or disapproved the entity. But things have become a little bit clearer with the new foreign investment law that will be implemented in January next year.
The foreign investment law was officially passed by the National People’s Congress in March. The new law has one significant difference compared to the draft issued in 2015. When defining foreign investment, it deleted the term that describes a foreign controller as a foreign investor. Instead, the law uses a rather vague term to define “direct” and “indirect” foreign investment.
These small changes have cut out references that would have invalidated the VIE structures that are used by tech giants such as Alibaba and Tencent. The new law has made the grey area in which they work a little wider.
“The new law didn’t give an executable standard for VIE-structured companies,” Mark Chen, an alternative investor in Hong Kong told FinanceAsia. “Lawmakers deliberately put ambiguity in definitions by deleting terms that describe a foreign actual controller as a foreign investor.”
A vague definition benefits Chinese capital markets, he added. If the new law were to define all VIE-structured companies clearly as foreign enterprises, a lot of Chinese companies, both public and private, would be forced to restructure their businesses. And that could have a huge impact on the Chinese capital markets.
The ambiguity on the definitition of VIE allows China to collect more taxes as more startups look at oversea markets. The founders of these startups still need to report tax in China under Common Reporting System (CRS) rules, as the new law doesn't recognise VIE-structured companies as foreign companies. If VIE-structured startups were to be recognised as foreign investments, then founders could avoid paying higher tax in China – a situation that the Chinese government wouldn’t want to see.
Now VIE structures are only a slight headache when companies want to file for an IPO. Hong Kong Stock Exchange updated regulations in April last year, warned that VIE-structured companies which didn’t apply to the new foreign investment law would have to sell their business, and would be at risk of delisting. The vaguer terms of the new law have reassured those companies with an acquiescent attitude from Beijing.
“For years, VIE has been the most common structure for Chinese tech companies that want to list overseas,” a Beijing-based lawyer commented. “And we do it so often that a package for a VIE structure is getting cheaper.” Now with the endorsement of a ratings agency, VIE-structured companies can stop worrying about their business structure – at least for now.
